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What’s Going On in the Markets August 23, 2015

August 23, 2015 — Sam H. Fawaz

Some of the most entertaining times to be a long-term investor are those periods when short-term investors are looking over their shoulders for an excuse to sell. They’re convinced that the market is heading down before they can get out, and so they jump on any bad news that comes across their Bloomberg screen.

Last Thursday and Friday was a marvelous time to see this in action. With all the economic drama playing out in the world, there were plenty of opportunities to panic. The Greek Prime Minister has resigned! Sell! … China devalued its currency a few days ago by 2%! Head for the hills! … Chinese stocks are tanking yet again! Get out of American stocks while you can! … The Fed might raise short-term interest rates from zero to very nearly zero! It’s the end of the world!

Of course, a sober analyst might wonder whether a change in governance in a country whose GDP is a little less than half the market capitalization of Apple Corporation, is really going to move the needle on the value of U.S. stocks—especially now that Greece seems to have gotten the bailout it needs to stay in the Eurozone. Chinese speculators are surely feeling pain as the Shanghai Composite Index goes into free-fall, but most U.S. investors are prohibited from investing in most companies in this tanking market. If the market value of PetroChina, China Petroleum & Chemical and China Merchants Bank are less valuable today than they were a week or a month ago, does that mean that one should abandon U.S. stocks? Does it mean that American blue chips are somehow less valuable?

What makes this dynamic entertaining—and sometimes scary—is the enhanced volatility around very little actual movement. You see the market jump higher and faster, lower and faster, but generally returning to the starting point as people realize a day or two later that the panic was an overreaction; and so was the false exuberance of realizing that the world isn’t going to come to an end just because we’re paying less at the gas pump than we were last year. Despite all the jitters investors have experienced over the past nine months, and despite the drop last week, the S&P 500 is only down about 4% for the year, and was in positive territory as recently as August 19.

Let’s summarize a few of the facts about this current sell-off:

Friday’s decline was 500 points in the Dow Jones Industrial Average (DJIA), which was 3.1%. During this bull market there have been 11 similar daily declines of that size (or larger), and in every instance the market went on to new highs. So Friday’s decline, by itself, does not mean that we’re in a bear market.

Last week’s loss in the S&P 500 Index was 5.77%. Since 1940, there have been 38 weekly declines of this size (or larger). Surprisingly, there were three times as many double-digit gains three months later than there were double-digit losses. So last week’s decline doesn’t necessarily indicate more big losses ahead.

Market readings are at the most oversold level since the 2011 correction lows. Historically, readings this low indicate a high probability of a rally or bounce in the week ahead.

For perspective… from the market peak earlier this year, the DJIA is off 10.1% through Friday’s close, and the S&P 500 Index is off only 7.5%. So far, this barely qualifies as a correction. And the last 10% correction was in 2011, so this was overdue. Since the year 1900, there have been 35 declines of 10% or more in the S&P 500. Of those 35 corrections the index fully recovered its value after an average of about 10 months. Sure, there’s no guarantee that the length of future recoveries will happen in a similar time frame, but the long term bias of the market is always up.

I’m not telling these facts to downplay the market’s weakness (which I’ve been telling clients to expect), but to convey that this correction may not be a full scale bear market. Bull market tops are long, drawn-out affairs. And while negative technical market signals have been building for the past few months, I cannot say with certainty that we are in a bear market…at least not yet.

Another positive development –not yet considered by today’s panicked sellers– is that this market weakness has likely taken the chance of any September interest rate hike by the Federal Reserve completely off the table. In fact, we’ll be surprised if Fed officials are not cajoling the markets with dovish comments this coming week to calm investor nerves and stabilize Wall Street.

If you want a broader, more rational picture of our current economic situation, read this analysis by a long-term trader who now refers to himself as a “reformed broker” in Fortune magazine: http://fortune.com/2015/08/20/american-economy-worries/. He talks about the “terrible news” that it hasn’t been this cheap to fill your gas tank in over a decade, and businesses that rely on energy to manufacture their goods, are now forced to figure out what to do with the excess capital they’re not spending on fuel. (warning: sarcasm to follow).

Oh, but it gets worse. American corporations are struggling under the burden of enormous piles of cash they don’t have a use for. They may have no choice but to return some of that money back to shareholders in the form of record dividends or stock buybacks. Of course, you read about the risk to corporate profit margins. It seems that unemployment is so low that wages for American workers are going up, and that could raise consumption and demand for products and services.

Meanwhile, contributions to 401(k) and other retirement plans are up dramatically, housing starts and the construction sector are booming, America’s biggest global economic competitor (China) is reeling, and the Federal Reserve might decide that it no longer has to keep short-term interest rates low because the emergency is over and the economy has recovered.

The author apologizes (tongue in cheek) for bringing us all this terrible news, but hey, we can always sell our stocks and get out until conditions improve. Right?

Nobody would be surprised if the U.S. stock market suffered a 10% or even a 20% short-term decline (correction) this year, or perhaps next year. Besides, we haven’t had a 10%+ correction in nearly four years. But what can you do with that information?

Nobody would have been surprised if this had happened at any point in the long bull market that may have doubled your stock investments, and nobody can predict whether Friday was a signal that the market will take a pause, or if Monday will bring us another wave of short-term euphoria measured mostly in sighs of relief. And if you don’t know when to sell in this jittery market, how will you know when to buy back in?

These short-term swings provide entertainment, but very little useful information for a mature investor. If you aren’t entertained by watching people sell in a panic and then panic-buy their way back in when they realize things aren’t as dire as the headlines made them out to be, then you should probably watch a movie instead.

What To Do

It is likely the media will have a heyday with the recent losses, and perhaps showcase predictions of much more dire things to come. The media is all about getting you to tune in, not to help you with investment decisions. When things are good, they highlight how great things are, and when things turn south they jump on the bandwagon and act like there won’t be a tomorrow. It’s best to tune them out.

As mentioned above, we are way overdue for a correction. Over the past six years, there has been much less volatility in the markets than there usually is. We have become a bit desensitized to how stock markets actually move. Losing 10% – 20% over a period of months is not unique. Markets go up and down; that’s why stocks pay us a premium to own them. Every time something different causes it and each time it instills a lot of fear. This time and times in the future will be no different.

If you have at least five to seven years until you plan to fully cash out of your account, then you have nothing to worry about. Even if we were to get a protracted downturn, it wouldn’t matter for long-term investors; in fact it can benefit you.

If the markets go down significantly more, expect to take advantage of the weakness and buy high quality stocks “on sale”. It’s never easy to buy stocks after seeing them go down, but it can really help your returns over time. A 5% correction is not sufficient to do this. I’d be looking for a 10% – 20% correction before putting more money to work.

Diversified portfolios, which you must have, ensure that your investments don’t move in line with the market. Sure, you don’t go up as much as the market, but you also don’t go down as much. And by having assets that do well in tough times such as cash, short-term bonds and inverse funds, we have the ability to actually purchase stocks on sale – to take advantage of temporary losses for your long term gain. The key is to think long term (five years or more) and ignore the short term stuff.

While I have no specific knowledge (or a working crystal ball), my guess is that the market highs are in for this year. That doesn’t mean we go down from here; it just means that it gets harder to make new highs before year end. Of course, I could be wrong!

In our client portfolios, we have been building up cash positions, taking profits on some positions, increasing our allocations to defensive sectors, and adding to our hedges for months now. If you’re wondering what to do, you might consider lightening up on some profitable positions into the next rebound if you haven’t already done so (this is not intended as investment advice-please check with your advisor so that changes made to your investments are consistent with your financial plan, risk tolerance and time horizon).

Because Friday closed on the lows, we could very well see selling pressure spill over into this week. Even so, we do not see last week’s swoon as the start of a waterfall decline or market crash. Taking into account how bull market tops unfold, we believe this top (if it indeed is one) will take more time to develop and offer more convincing evidence of a bear market.

We will be closely watching the coming rebound. If we continue to see deterioration in breadth/leadership (the number of stocks going up are less than those going down), and the technical health of the markets deteriorate, then we will increase our cash reserves, hedges and defensive sector allocations. If this turns out to be a wonderful buying opportunity, then we may not catch the absolute bottom, but there will be plenty of time to take advantage of this latest “dip”.

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first. If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.